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    With fund managers increasingly investing across multiple jurisdictions – each with their own unique rules – firms need to ensure that not only are they wholly compliant with local tax obligations, but that these requirements are accurately reflected in fund pricing. This paper discusses the key factors and considerations for fund managers managing the complex world of capital gains tax (CGT) and provides an in-depth analysis on how they can best manage the process. The taxation of funds has become increasingly complicated with more jurisdictions introducing Capital Gains tax (CGT) on foreign portfolio investors (FPIs), adding complexity to organisations' tax accounting policies and operational tax processes.

    The taxation of funds has become increasingly complicated with more jurisdictions introducing Capital Gains tax (CGT) on foreign portfolio investors (FPIs), adding complexity to organisations' tax accounting policies and operational tax processes.

    Funds have, for many years, paid taxation on dividend and interest income. The payment and accounting processes underpinning these taxation calculations are well understood.

    So why is the extension of taxation to capital gains creating new challenges for funds?

    The key to understanding these additional challenges is to compare and contrast the taxation of capital gains with the taxation of income as highlighted in the table below.

    Points for Consideration Tax on Income CGT Impact of Differences
    Does taxation basis differ from accounting? Tax is generally applied to income as recognised for accounting purposes. Tax is often applied to capital gains calculated on a different basis from the capital gains recognised in the accounts. Calculation of tax on income can be easily automated as the tax is calculated by reference to an amount recognised for accounting purposes.
    Where CGT is calculated on a basis which diverges from the accounting basis, a separate tax book of records is required leading to additional complexities.
    Tax Rates – consistent or different? Consistent tax rates are generally applied to each type of income. Different tax rates can apply depending on the asset holding period. Consistent tax rates for taxation on income lends itself more easily to an automated systems' solution.
    Mechanism of tax payment Tax is generally automatically withheld at source. Tax is often not due conterminously with the disposal transaction and can require the asset holder to appoint a tax agent. Additional costs and administration associated with CGT.
    Complexity of Tax Calculation Withholding tax is generally applied to the individual income payment with no requirement to consider offsetting it against expenses/losses. Tax rules often allow carry forward (and sometimes carry back) of losses with jurisdictions having their own individual rules. Jurisdictional specific rules on carry forward of CGT losses requires separate solutions across each tax jurisdiction.
    Impact of Tax Losses Tax credits/assets on losses not relevant. Where tax rules allow carry forward of CGT losses, recognition of CGT losses can give rise to complex judgement considerations. Recognition of losses requires management judgement and subjective decision making which cannot be wholly automated.

    Accounting for Income and Capital Gains Tax

    The two primary accounting standards used for taxes are the International Accounting Standard 12 'Income Taxes' (IAS 12) and US GAAP Accounting Standards Codification 740 (ASC 740) Income Taxes.

    The income tax accounting framework under both IAS 12 and ASC 740 are consistent in terms of their approach towards the recognition and measurement of income taxes. The differences between the two standards are largely irrelevant for the purposes of this paper. These tax accounting standards cover the:

    1. timing,
    2. measurement and
    3. recognition criteria for income taxes

    These requirements should be followed for accounts prepared under IFRS and US GAAP respectively. While there may be no specific requirement for either accounting standard to be followed when determining the timing, measurement and recognition of tax in the NAV of priced funds, these two standards are a useful guide to what management may wish to consider when determining the quantum of taxes to include in their funds' pricing.

    Key Aspects in Accounting for CGT

    A) Frequency of Accrual

    Many funds publish a daily price which reflects the NAV of the investment vehicle enabling investors to purchase or sell units at a price based on their share of the underlying assets. Where a dividend is declared on an equity held by a fund, the dividend is recognised as income in the fund's NAV, with the related withholding tax (if any) recognised concurrently as a tax expense. An investor purchasing or selling units in the funds will trade at a price which not only recognises the income earned by the fund but also any tax charge on that income. Similarly, if there is a potential capital tax exposure, reflecting this in the published NAV facilitates the appropriate payment for the underlying fund assets by the incoming and outgoing unit holders.

    B) Inconsistency of Tax Basis with Accounting Basis

    Where a fund is subject to CGT (e.g. Indian, Pakistan or Brazilian CGT) it is often calculated on a different basis from average cost which is used for accounting purposes, e.g.

    • Indian and Pakistan CGT is based on a FIFO1 basis.
    • UK CGT which applies to unit linked life insurance funds uses a share pooling and 10 day matching rule approach.
    • Brazilian CGT2 – while typically using an average cost – diverges from this basis where there is a same day purchase and sale or in the event of corporate actions.

    The divergence from the accounting gain or loss for CGT purposes causes a significant amount of additional complexities in accurately calculating CGT. This gives rise to practical challenges for pricing funds.

    C) Single or Differing Tax Rates

    The CGT rates in a number of tax jurisdictions are dependent on the holding period of the asset. Rules vary across jurisdictions and while the application of differing rates can be tracked via tax tables facilitating automation, the existence of these different rates requires management to make a determination about what is an appropriate holding period to assume. Management assumptions regarding the holding period of assets should form part of their accounting policy for tax. The assumptions made should also be consistent with the funds' investment policies disclosed in prospectuses or other public documents. These should be updated to reflect changes in the investment approach too.

    D) Tax Losses and recognition of deferred tax assets / liabilities

    Withholding tax is typically applied to dividend and interest income without any deductions for expenses leaving tax on such income to be, in almost all cases, a tax charge or liability. The capital return on an asset can, however, be a gain or a loss meaning that CGT can lead to either a charge on a capital gain being levied or a credit allotted in circumstances where there is a capital loss.

    Jurisdictions do not generally give a tax refund where a taxpayer has incurred a capital loss. Instead, they often allow such losses to be carried forward (and sometime back for a limited period) to offset future capital gains. Determining whether it is appropriate to recognise tax losses is a complex area which requires careful judgement.

    Case study: India

    A key provision contained within the Indian Finance Minister's February 1, 2018 Union Budget was aimed at FPIs, namely the introduction of a Long-Term Capital Gains Tax (LTCG) rate of 10 per cent. The LTCG, according to the Finance Minister, is 'a modest change' to the existing CGT regime3, but its impact will be felt heavily by FPIs transacting in the Indian market.

    The taxation of funds has become increasingly complicated with more jurisdictions introducing Capital Gains tax (CGT) on foreign portfolio investors (FPIs), adding complexity to organisations' tax accounting policies and operational tax processes.

    Prior to the 2018 budgetary announcement, FPIs were only taxed on Indian short-term gains, namely gains on assets held for less than 12 months. Most firms therefore did not need to accrue for Indian CGT in the fund price as their holding period of assets was generally more than one year, meaning no CGT was payable. In cases where the assets were disposed of within one year, the CGT payable was recognised in the fund price when it was incurred. This made the approach operationally straightforward as tax expenses were only recognised when the CGT was paid out of the fund's bank account.

    With the introduction of a 10 per cent rate of CGT on LTCG in addition to the existing 15 per cent rate on Short Term Capital Gains (STCG), funds which hold Indian securities can no longer avoid paying CGT simply by holding securities for more than one year. Funds where Indian CGT is material to the fund price now need to consider accruing for unrealised CGT rather than simply recognising CGT on a paid basis.

    Accruing for Indian CGT gives rise to a number of operational complexities including:

    1. Tax agents who calculate the realised CGT due will be tax specialists but may not necessarily be expert in tax accounting, so care may be needed to ensure that the tax accounting calculations and the assumptions underpinning them are correct.
    2. In practice, timing differences can arise between the recognition of the amounts within the tax accrual and the tax payments made, so it is important that funds put appropriate controls in place to ensure that realised CGT amounts are neither excluded from the fund price nor double counted.
    3. There is a need to ensure consistency between holdings, market value and proceeds used in the calculation of the CGT accrual and that in the fund Net Asset Value (NAV).
    4. It will be necessary to automate the accrual process and surrounding controls. This automation is particularly important where a CGT accrual is calculated daily for inclusion in the fund price.

    HSBC Securities Services is implementing a new Indian CGT service that will provide clients with a complete solution to the operational complexities they face when accruing for tax. The proposed solution includes the actual calculation of Indian CGT being performed by a Big 4 firm with both tax specialist knowledge of Indian CGT and expertise in tax accounting. This will be coupled with the strong operational controls operated by HSBC Securities Services ensuring that tax payments are appropriately accounted for and that there is consistency between the NAV market values and proceeds and those used in the CGT calculation.

    Complexity of Recognition of Tax Losses

    IAS 12 and ASC 740 require, with only very limited exceptions, the recognition of tax charges or liabilities. The hurdle for recognition of deferred tax credits or assets, particularly where the entity is in an overall net tax credit or tax asset position is considerably higher. For both accounting standards, the recognition criteria is broadly the same with a net tax asset position being recognised where it is more than 50 per cent likely4 that such an asset can be used.

    The recognition of net tax asset positions is one of the more complex and subjective areas of accounting for income taxes. In circumstances where the amount of tax assets are material in the context of a funds' NAV or statutory accounts, the recognition of such assets should be carefully considered and be reasonable to help ensure fair treatment of customers who may enter and leave the fund at different times (TCF5).

    Tax Accounting Policy Considerations

    All of the above aspects should be defined in the tax accounting policy and operating model. The following criteria should be used when defining the accounting policy:

    • Whether the impact of CGT is likely to be material in the context of fund pricing. This may help determine whether a high-level approximation could be considered appropriate or whether an accurate calculation of CGT is required.
    • The holding period over which it is assumed investments will be held where a jurisdiction allows for differing tax rates dependent on holding period. The holding period assumptions should be checked for consistency with (a) the funds' aims (i.e. growth fund or speculative fund), (b) published prospectuses and other documents and (c) actual experience of the fund.
    • The tax rates to use. For example, if there has been an announced change in tax rate which will apply from a set period, consideration should be given to the appropriateness of using this rate for disposals expected to occur after this time.
    • The consistency of assumptions must be verified. For example, the fund's holding assumption may impact both the tax rate and the costs allowed for tax purposes and these must be consistent with each other.
    • Recognition of capital losses, particularly where a fund has an overall net loss position. Factors that managers may wish to consider when determining whether or not to recognise a value for such losses are: (a) accounting standard requirements of more than 50 per cent likely, (b) length of time over which losses can be carried forward (some jurisdictions [e.g. UK] allow indefinite carry forward of losses whereas other jurisdictions [e.g. India] allow carry forward for a maximum number of years), (c) any restrictions on the quantum of losses carried forward and (d) whether the fund is expanding or contracting in that particular market.
    • Whether it is appropriate to diverge from the accounting policies used in the fund's statutory accounts for pricing purposes (e.g. the use of discounted rates for net tax asset positions in pricing even though such discounting is prohibited by IAS 12).

    Operational Aspects of Implementing the Tax Accounting Policy

    Operational points to consider include:

    • Who should calculate CGT for inclusion in the NAV? Is it preferable for those responsible for the NAV calculation to also be responsible for the calculation and booking of CGT in the NAV? Perhaps given the specialist and jurisdictional specific nature of CGT calculations, management may consider it more appropriate to have a specialist tax consultant perform the CGT calculations.
    • What controls should be put in place over the CGT calculations? It will be important that controls are put in place to ensure that the CGT calculations use market values and proceeds which are consistent with those in the NAV. A reconciliation of holdings is also good practice. In scenarios where a daily CGT accrual is included in the fund price, it may only be possible for these controls to be performed by the fund administrator responsible for the calculation and publication of the fund price. It should be noted that where the tax basis and accounting basis are different, there will be a divergence in the cost between the two bases.
    • Reconciliation of cash tax payments to accruals booked: This will be important to help ensure an accurate basis of accrual. Differences between the amount accrued and the actual cash tax ultimately paid should be investigated and understood.

    The tax accounting policy and the operating model should be agreed with the Fund Board or Audit Committee and subject to regular review to ensure it remains current.

    What should Fund Managers do?

    With the emergence of CGT charges in a number of leading emerging markets (e.g. India, Pakistan, Brazil etc.), fund managers should ensure that they:

    • Are aware of those jurisdictions where they hold investments which charge CGT on FPIs.
    • Have appropriate arrangements in place to meet the fund's legal obligations to pay taxes in the relevant jurisdictions.
    • Ensure that their funds account for taxes appropriately within their NAV and statutory accounts.
    • Define the Tax Accounting Policy taking into account the above considerations.
    • Define the Operational model for calculation and inclusion of CGT in pricing.
    • Consider the cost of tax services for those funds which are materially exposed to markets that charge CGT. Such funds would be expected to include a materially accurate CGT accrual within their pricing. Choosing an experienced and efficient service provider for the calculation of CGT will help ensure an accurate CGT calculation in a cost effective way.

    HSBC Securities Services support for Fund Clients

    HSBC Securities Services has noted that taxes on FPIs are being introduced more regularly. Recent examples include the introduction of CGT in India on long term gains (beginning April 1, 2018) and the 871M tax charges on dividend equivalent amounts introduced by the US in 2017. These reforms expand the tax base across all impacted jurisdictions.

    They are either aimed at counteracting perceived avoidance (871M) or, in the case of some developing economies designed to increase the tax base to fund development.

    Regardless of the intent behind the introduction of these taxes, the effects on funds is the same, namely an increasingly complex and broader tax exposure. Impacted firms need to manage this in a comprehensive and controlled manner.

    HSBC Securities Services is responding to the evolving tax challenges faced by its clients by implementing a new global model for tax services. This end-to-end solution, live in 2019, will ensure clients receive the same consistent tax service for their funds across Europe, Asia Pacific and the Americas.

    For further information, please contact one of our specialists below.

    1 First In First Out

    2 Only applies to funds which are tax resident is jurisdictions which have been blacklisted by Brazil

    3 Budget 2018-2019; Speech of Arun Jaitley, Minister of Finance, February 1, 2018

    4 ASC 740 'more likely than not' and IAS 12 'more probable than not'; with both requirements considered to be more than 50 per cent likely

    5 Treating Customers Fairly

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